Last time I did a really simplified overview of Modern Portfolio Theory. Much of the credit for this is due to a fellow name Harry Markowitz, who figured out that if you combine two assets with the same return that aren’t perfectly correlated, this diversification can result in reduced risk without reducing return. Even if you don’t combine two assets with the same return, combining two assets that have low correlations (don’t move together) will get you a better reward/risk ratio. Markowitz later won a Nobel Prize for his work in this area.

Stocks vs. Bonds
Studies have shown that somewhere between 77% and 94% of the variability in portfolio returns are determined by asset allocation. So our goal is to use asset classes with low correlation to get the best reward/risk ratio. One of the most popular examples of assets that have low correlation is stocks and bonds. Accordingly, adjusting your ratio between stocks and bonds is one of the most basic ways to adjust the amount of risk you wish to take in a portfolio.

The chart below shows the risk/return trade-off between bonds and stocks for 1980-2004. The stock portfolio is represented by the S&P 500 index, while the bond portfolio contains 60% five-year Treasury notes and 40% long-term Treasury bonds. The portfolios range from 100% bonds, to 95% bonds/5% stocks, 90% bonds/10% stocks, all the way to 100% stocks. (via this AAII article)

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Building upon the idea of investing in broad markets, next up is Modern Portfolio Theory. This is another advanced topic that entire careers can be built around, but here is my attempt to explain it in one quick digestible chunk.

Risk vs. Reward
As far as investing goes, the most basic component we have is cash. If we invest it in a Treasury bill from the government (as riskless as possible), then we will end up with a return after inflation of zero. You just keep up with inflation. No risk, no reward. In order to increase our reward we, must take on more risk. But it’s not a linear relationship. We want to find the mix of investments that offer the best mix of risk and reward. So again we turn to history and whip up some math. (I’ll go easy on the numbers here.)

Reward = Return
The idea of reward is usually represented by the historical average annual return of the investment. Sounds good to me.

Risk = Standard Deviation
The idea of risk has many possible definitions. Stocks are seen as riskier as bonds, because their prices have historically fluctuated much more wildly. For example, for domestic stocks, your best year would be +39% while your worst year would be -28%. In contrast, for a broad bond portfolio, your best year would have been +31% while your worst year would be -8%. (Source: Vanguard) A mathematical way to measure this volatility is standard deviation. The larger the standard deviation, the higher the risk.

Mix ‘Em Up
An asset class is a group of investments that exhibit similar characteristics. If we plot their historical returns vs. historical standard deviations, we might get something like this:

One dot might be the S&P 500. Another dot might be 1-Year Treasury Bonds. Now, what if we starting mixing them up into in various ratios. Like taking 50% S&P 500, 25% US Small Cap, and 25% 5-Year Treasury Bonds. We’ll get a whole lot more dots, err… data points:
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I am starting a new series of posts that describes how I will reconstruct my current investment portfolio from scratch, from general theory to the actual purchasing of specific mutual funds. Here I want to reiterate the point of this blog – This is how I am thinking of investing my money, not necessarily how I think you should do it. In other words, I don’t claim to be an expert, I just think sharing is fun and hopefully there will be a good debate and overall knowledge will be increased. You don’t really often get to see someone juggling a real portfolio across a multiple Roth IRAs, 403bs, 401k, and taxable accounts. It will also keep me organized and motivated as I’m been putting this off 🙂

General Philosophy
Here are some quick insights into how I approach investing. You’ve all read this ominous phrase before:

Well, you know what? All we have is past performance. The important thing is to look back at all the data available, and try to extract useful information that has the greatest chance of persisting into the future. This won’t be easy, and there will be eternal debate as to how where we draw the line between “likely to persist” and “unlikely to persist”.

Based on this life expectancy chart, if I’m lucky I’ll have another 50 years of investing ahead of me. However, much of the data I read about in studies only dates back no further than 1975. Even the really far-reaching ones only date back to 1926. So I’m supposed to use at best 80 (and often only 25) years of data and extrapolate that out for another 50 years? That doesn’t seem like a huge mountain of evidence, especially considering events like World War II which had huge consequences and occurred only 50 years ago. Wouldn’t it be nice to have something like 800 years of investment data to make decisions upon?

As a result, I will try to keep my portfolio simple and stick to things that I believe are the most reliable, including supporting articles and data. Most of this will come from my readings of books and various studies.

Read more: Index of Posts On Building My Portfolio

Actually, a better question is what percentage of your income should you contribute to all types of retirement plans? But the 401(k) plan is one of those cases when you have to choose something to start out with, and many people just never get around to changing it again. Too much, and your cashflow will get tight and uncomfortable. Too little, and you’re not taking full advantage of the tax benefits.

Start With The Match
As everybody says, matching contributions from your employer will probably offer the best return-on-investment you’ll ever get. Most companies have a cap after which the match stops, and my guess is that most people contribute up to that cap and then forget about it. Certainly, this number provides a floor, but most of us will have to chip in some more to accumulate a happy nest egg. (I’ve never heard of a match above 6% of pay, although I’m sure some exist.)

Take Into Account Other Accounts Like Roth IRA
The reason people like Roth IRAs is that if you think your tax situation now will be about the same as in retirement, the Roth IRA has a lot of extra advantages like the ability to make early withdrawals for a variety of reasons, as well the ability to never make any withdrawals and leave it to your heirs still compounding away. However, if you have a Roth 401(k) the difference gets a lot slimmer, you may just go with which one offers you better investment choices. Either way, it’s good to consider the whole picture.

Mint.com allows you to compare different IRA accounts available online … if you want to see how your IRA stacks up against what’s available, you should check them out.

Taken all together, I would say 10% would be good place to start unless you have a pension or other sources of retirement income lined up. But that’s just me… what do you think?

Each 1% More Can Make A Big Difference
On top of that 10%, it’s interesting to see how much difference nudging it up another 1% can do. I used this Increase 401k Contribution Calculator from Wachovia and ran some numbers. Assuming you make $50,000 gross annually, you’re 35, you retire at 65, 8% annual return, and a 25% income tax bracket, here’s what happens if you increase your contribution percentage by 1% (unmatched):

Not too bad for giving up just $31 per month; if you’re younger the payoff is even better. (Almost good enough to bump up your contributions by 1% today?) Still, start taking enough $31s out and it’ll start to hurt.

Give Until It Hurts?
To find the nice balance, there are a couple of ways to do it:

1. Analyze your finances, estimate a percentage, and just adjust from there. (More work.)
2. Start at match %, and keep increasing the % until it starts to hurt.
3. Start at a high amount (20%? 25%?), and keep decreasing it until your take-home pay is a manageable amount.

Each person probably has a different preference. But again, we go back to the real-life aspect – Will you remember to change your percentages later? Life gets busy, and each month you just keep forgetting and forgetting… In that case perhaps the third option is best, assuming you have some cushion to pay with.

Everybody loves 401k plans for their tax advantages. But exactly how good are they, really? What if your 401k only offers limited, more expensive options than you can find from a regular brokerage account? I wanted to explore this using some estimated numbers, just to see how it works out. I know my assumptions won’t fit everyone, but people can adjust them to be closer to their own situation.

Assumptions

1. Start with a $10,000 pre-tax contribution for each
2. Both plans have the same imaginary investments for 30 years
3. Annual return on those investments is 8%, broken down into 6% from capital gains, and 2% in qualified dividends. This is to approximate the amount of dividends currently being paid on stocks in general.
4. 28% ordinary tax bracket both now and upon withdrawal in retirement
5. 15% tax bracket for long-term capital gains and qualified dividends
6. Any company matching is ignored, as everyone should contribute up to the match. 🙂

401k Calculations
The calculations for the final value of the 401(k) are relatively simple. You start with $10,000, it grows at 8% annually without any tax consequences for 30 years, and then upon withdrawal it is taxed at ordinary income tax rates. With our assumptions, the math would look like this:
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